A lot of people think that a mortgage is just a loan they take out to buy a home, which they pay off over the years. Owning your own home outright is often the goal, and maybe the only goal, and while this is a nice situation to be in, there’s a lot more to managing mortgages properly than that.
If a mortgage were the only debt that someone had, then things would be this simple, although even then there’s the matter of how much money that you keep in reserve, your savings set aside for everyday financial management, versus how much you pay down your mortgage with.
There are plenty of people who pay down their mortgage as aggressively as possible, to the point where this ends up costing them quite a bit more money. Even in the case where one’s debt obligations are limited to their mortgage, if they do not have sufficient reserves to manage upcoming purchases, including unexpected ones, then they will be forced into borrowing, usually at much higher interest rates.
In the majority of cases with today’s home owners, this other borrowing does come up a lot and most often people will have other debts besides their mortgage when they take it out, and have these other debts years into the mortgage, and often for the entire life of it.
Without proper planning, this can get much more expensive than it needs to, and people can also find themselves in financial difficulty and even end up defaulting on their obligations and destroying their credit due to poor planning overall with their mortgage.
The Two Main Goals in Debt Management
Paying the least amount of interest overall is obviously a primary goal of debt management, and managing our personal finances in general. It is never about paying the least amount of interest on a given debt, such as minimizing the interest we pay back on our mortgage over the years, it is the overall interest we pay that must be considered.
The second goal is to allow ourselves to manage our finances and have the resources available to get what we want and need, within reasonable limits, but especially to be able to access funds when we really need it, either from our own funds or at reasonable rates.
We need to seek to strike a proper balance between these two goals, as they are often competing. Paying off debt can often limit our ability to manage our finances, and can lead to paying more interest rather than less if we’re not careful, and may even lead to default.
From the moment we first get our mortgage, it pays to be aware of the dynamic here and do our best to put and keep ourselves in a good position to manage both these goals properly.
When we buy a home and take out a mortgage, we often have to decide how much we want to put as a down payment on it, assuming we have access to more than the minimum down payment that is. If we don’t, it’s a simple matter, and we’re actually forced into doing the right thing here, given such limited financial resources.
For most people anyway, a good rule of thumb is to not put down any more than the minimum on a mortgage, although if one has enough extra savings to make a bigger one and not have this impact their finances, a larger one can be a good idea.
The only way this ever makes sense is that if one does not have any other debts and does not expect to need to borrow at all during the life of the mortgage. There aren’t a lot of people so fortunate though, and the vast majority of people either have debt or likely will at some point.
If we put this extra money on the mortgage, let’s say an additional $20,000 that we have, if we have other debt, this debt will be at a higher interest rate and it would instead make sense to use it to pay out the higher interest debt if we’re looking to use it to pay down debt.
If one has no debt but may at some point, then this isn’t quite as simple, and we need to look at the difference between the mortgage rate and the rate we can get with a savings account or other shorter-term savings vehicle, which will be our cost. The benefit will be the extra interest we will save if we have to borrow it at a higher rate, or saving the cost of refinancing our mortgage to add this debt to it.
So it’s not that either approach isn’t without its costs and risks, and this is where the balancing comes in. We don’t need to do any sort of complicated calculations here, as the important thing is to simply be aware of how this all fits together and decide based upon what we reasonably expect.
With most people, if not the overwhelming majority, this will end up being a simple calculation and it will come down to wanting to have enough money in reserve if they can manage it to avoid having to borrow, or limit the amount of borrowing they will need to do,
Mortgage Management is Ongoing
Another key decision that we need to make, both at the beginning of the mortgage and as we renew it into new terms if it is a multi term mortgage, as well as if we choose to refinance it, is what to set our payments at.
Just like people tend to be too aggressive with the amount of their down payments, they also like to be too aggressive with their payments, once again thinking that they are well served by paying off this huge amount of money owed as quickly as possible.
This is often a mistake though and can end up being a big one, costing people thousands of dollars as well as making managing their day to day finances considerably more difficult.
People don’t tend to plan well and if they expect that mortgage advisors will help them very much with this planning they are in for a rude surprise. Even when things go sour and people get themselves in all sorts of financial trouble, and need to do expensive refinances to bail them out, the goal tends to be to just get them back on their feet and not pay anywhere near enough attention to preventing all this from happening again.
If, for instance, we don’t both add this other debt onto the mortgage and reduce their overall payments enough, then this usually spells trouble. This can actually end up making things worse later, as the next time they may not have the equity to come to their rescue, and there may be no alternative but to have to severely restrict their spending to uncomfortable levels, or even have to declare bankruptcy.
There are people who have set their amortization too short and their payments too high, and by the time they look for help, their credit may be shot and there may be no good options left for them. They may end up losing their homes in situations where this may have been preventable with better planning.
Even with the right advice, which people don’t get very much, borrowers often have a tendency to resist doing the right thing, for instance setting the amortization of their mortgage from 20 to 30 years, as this appears to make the past 10 years of paying down their mortgage wasted.
Extending the amortization only serves to reduce their minimum payment on their mortgage so that they aren’t painted into a corner with a higher payment they may not be able to manage later. They still can pay off their mortgage in the original 20 years or even quicker should they desire and have the means to do so, but only if they do, and if they do not have the means then this isn’t a realistic option anyway.
Ideally, we should be setting this minimum payment at a very comfortable level to start with, and while people still may need to extend the amortization later if needed, the chances of having to do this is higher if you aren’t set up to be able to handle a certain payment over time.
It’s All About Future Spending
People need to not only look at their current spending levels, they also need to look ahead and make sure that a certain mortgage payment is a good idea in the face of having to meet other debt obligations.
If you have a choice between a lower and a higher mortgage payment, as people usually do, it simply does not make sense to choose the higher one and have this directing more of your income toward paying off lower interest debt at the expense of using it to pay off higher interest debt.
As simple as this sounds, this is not something that people think about enough, and usually don’t think about it very much at all. All they see is a six figure debt and get locked in and even obsessed about paying this off, to the point where it blinds them to a more sensible approach.
One should never make extra mortgage payments over the bare minimum while holding higher interest debt. The fact that people do not tend to approach their mortgage payments this way is a real concern.
As they build up equity, much of which simply comes from increasing property valuations and not from paying off the mortgage, then this equity needs to be used as a tool to manage both present and future debt, and especially to look to replace higher interest borrowing power with lower interest secured lines of credit or collateral mortgages, which serve a similar purpose.
The purpose here is to be able to borrow more cheaply when one needs to, and ideally we wouldn’t need to borrow, but the truth is that people do. When they do, it only makes sense to want to do so at the lowest rate possible, and this often takes planning.
The overall goal here needs to be to think ahead and to also think about the big picture, not just how fast you can pay off your mortgage. Paying off your mortgage is great, paying off your debt is even more important and the only thing to focus on really.